The Labor Department reported consumer prices jumped a greater-than-expected 0.8% in July, while the adjusted core rate rose 0.3% for the second straight month. Both readings ran hotter than economists and investors had anticipated.

Over the past year, consumer prices were up 5.6%, the biggest on-year increase since January 1991. See Economic Report.

"The market's focus has shifted to the economy and how much it is contracting and not how much things cost a month ago," said Kevin Giddis, managing director of fixed income at Morgan Keegan & Co., explaining why Treasury prices are higher, even though inflation surged at both the headline and core levels.

"Jobs continue to be lost and more and more Americans are filing unemployment claims," Giddis said in a research report.

Also Thursday, the Labor Department said first-time applications for state unemployment benefits fell by 10,000 in the latest week to 450,000, while the four-week average of new claims rose by 19,500 to stand at 440,500, the highest since April 2002. Read full story.

"The yield curve is flattening somewhat today because the market is telling you that the Fed may have to do something other than wait and watch the U.S. economy fall into a deeper recession," Giddis said.

Fed's Stern sees weak recovery

The U.S. economy is fighting headwinds from a severe credit crunch and will probably grow only modestly until easier credit is available, said Gary Stern, president of the Minneapolis Federal Reserve Bank and a voting member of the Federal Open Market Committee.

"Given the headwinds associated with the financial shock, the economy appears likely to be restrained until credit conditions improve, as they inevitably will," Stern said in a speech on Thursday in Three Forks, Montana. See The Fed.

On Wall Street, U.S. stocks climbed for the first day in three, with the financial sector fronting the gains, as investors brushed aside negative economic data and focused on recent dips in the price of commodities. See Market Snapshot.

"Today's rally in equities highlights the process by which investors are becoming/will become numb to weak economic news," said Tony Crescenzi, chief bond market strategist for Miller Tabak & Co., in a note Thursday.

"The key to making money in riskier assets between now and the end of the year is to decide whether investors are in fact ready for the bad news to come," he said.

In the commodity markets, crude-oil futures fell amid concerns about a slowdown in global oil demand. See Futures Movers.

The price action in bonds is also tied to the strengthening of the dollar and the roughly $30-a-barrel recent decline in oil prices, "suggesting the future inflation numbers will be lower," Giddis said.

In the foreign-exchange action, the dollar rose against the euro after data showed that economic growth in the 15-nation euro zone shrank 0.2% in the second quarter, a reversal from modest growth in the first three months of the year.

Intraday Data provided by SIX Financial Information and subject to terms of use. Historical and current end-of-day data provided by SIX Financial Information. All quotes are in local exchange time. Real-time last sale data for U.S. stock quotes reflect trades reported through Nasdaq only. Intraday data delayed at least 15 minutes or per exchange requirements.